The Waiting Game

WHAT DID OPTIONS INVESTORS do last week? They watched stocks rise, then recede, then rise again. They browsed for trading ideas. They made plans to shovel snow. But, mostly, they waited.

Times like these, with the market in a state of deferred action over the Iraq standoff, the natural inclination is to think about selling options in general and calls in particular. After all, options are wasting assets that lose value over time, and sellers earn welcomed cash while stocks go nowhere. With the market factoring in a rich war premium, the ranges many stocks traded in have been narrower than that anticipated by their option prices, so there is a good chance that sold options may not even be exercised.

But selling options is daunting in this uncertain time (which is why investors shouldn't broach trades where the risks aren't defined). More important, money managers don't want to sell calls now, because that essentially surrenders upside gains beyond a certain point. That may be acceptable in a stagnant or slipping stock market, but, with hopes high for a monster rally if the Iraq situation is resolved, many investors balk at capping their upsides.

What that overlooks is how covered call-writing can outperform the market even in some rallies. Lehman Brothers strategist James Hosker compared returns from an adjusted S&P 500 Index, or SPX, and the Chicago Board Options Exchange BuyWrite Index, or BXM, which tracks a hypothetical portfolio of SPX stocks in which an investor also regularly sells one-month, out-of-the-money calls.

He found -- no surprises here -- that the BXM outgunned the SPX for the first three quarters of 2002, when stocks were flat or fell. The surprise? The BXM outdid the market from Oct. 9 to year end, even when the SPX rallied 13% -- largely because implied volatility at that time was so unusually rich that the premium earned compensated for the surrendered upside.

In fact, Hosker found the BXM beat the market in 99 of 156 months from 1990 to 2002. The exceptions? Often when the SPX surged more than 4.79% in a month.

"In other words, if you think the S&P 500 is going to do better than 4.8% in a month, you may want to hold off from covered-call writing," he says. "But otherwise, on average, it's a pretty sound approach."

But things are trickier now that implied volatility in many indexes and stocks have declined from October highs. So call sellers adjust. Charles Dobson, who manages the Dobson Covered Call fund in Santa Ana, Calif., says he is selling calls that expire later -- say, in three or four months, rather than the one-to-three-month calls he usually writes. "People seem to be anticipating a big rally further down the road and are more prepared to pay for these further-out calls," he says.

That isn't all. With everyone greedily awaiting a rally, contrarian traders now fear that a surge, if it does come, could be a letdown -- making call selling a smart move now. But even if a big giddy bounce does arrive, there's no reason nimble call sellers have to miss out.

Sell call spreads instead of calls, suggests Goldman Sachs strategist Joanne Hill. Call spreads may limit the premium earned, but they cap potential losses, so the investor wouldn't have to sell stock in a surprise rally. "Or, work out a staggered-strike strategy," she says. This involves divvying up the stock position into portions, and selling calls with different, or increasing, strikes against each portion. "That way, you avoid bumping up against this hard cap beyond which all gains are lost," she says.

Meanwhile, the volatility picture remains tough to read. Implied volatility of one-month, SPX index options has risen 6% since Jan. 15 as traders priced in a war-anticipation premium. But trading volume and actual volatility have been subdued, and the gap between implied and actual volatility remained near five-year highs, notes Goldman strategist Buzz Gregory.

That pattern mirrors the runup to the 1991 Gulf War. Then, the two sharpest spikes in implied volatility came soon after Iraq's invasion and just before Congress backed a war. Both times, implied volatility jumped by 13% to 16%, but declined within two weeks of peaking.

But today's standoff could be different, coming three years into a harrowing bear market still smarting from the pricking of a huge bubble. "With international disagreement regarding the need for a war, the current holding pattern of high uncertainty and inflated implied volatility could be protracted," Gregory notes. "The threat of global terrorism and the unknown duration of potential conflict" can affect risk perceptions and keep implied volatility high for a while.

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